WALL STREET, CALIFORNIA | INVESTING 101 / KATHY M. KRISTOF

If Bond Isn't Your Word . . .

They belong in every investor's portfolio. Here's a guide to what they can and can't do for you.

The stock market's dazzling performance, particularly lately, has convinced most investors that equities are worth owning. But the same can't be said of bonds.

Their yields have been lackluster in recent years. So have their total returns, which take price movements into account. Moreover, largely because some investors define the bond market as just Treasuries, there is a perception that bonds are simply too dull.

Still, virtually every seasoned financial advisor suggests that investors--no matter how young or old--should have bonds in their portfolios. But a market that includes the likes of corporate junk bonds, Third World bonds and exotic derivative issues is anything but dull. In fact, certain segments are far too volatile for investors who can't tolerate a lot of risk.

Although bonds generally return less and pose less risk than stocks, that's not always true. The last time the stock market went through a down period, in the 1970s, the return on two-year Treasury notes--one of the dullest fixed-income investments--handily outpaced that of stocks for a full decade. In 1982, when interest rates were finally beginning to drop after hitting historic highs, the Standard & Poor's 500-stock index posted a healthy 21.6% return. But the return on 30-year Treasury bonds was far better: 43.6%, thanks to falling interest rates that sharply boosted the price of those bonds, says Joan Payden, chief executive of Payden & Rygel, a Los Angeles-based money management firm.

"We are always tainted by what happened last," Payden says. "But at some point in time, bonds will do better than stocks."

In addition, returns on stocks and bonds can and frequently do move in the same direction at the same time, but rarely do they move at the same pace. Sometimes returns on stocks and bonds move in opposite directions, which makes them a ideal duo for diversification, smoothing the bumps in your investment portfolio.

How do the risks and rewards of bonds compare with stocks?

When you invest in bonds, you are in effect lending the issuer money. In return, the issuer promises to pay back your principal at some time in the future and to pay a set rate of interest for as long as the bond is outstanding. Consequently, you face two risks--of default and of interest rate fluctuations.

Default risk is the chance that the issuer--be it a government or a corporation--will get into financial hot water and be unable to pay all or part of the principal or interest. The amount of default risk varies dramatically by the type of security.

Treasury notes and bonds are believed to be virtually free of default risk because the U.S. government is highly credit-worthy. The default risk on debt issued by highly indebted companies or Third World countries, on the other hand, is fairly substantial.

Because risk and reward go handin hand, an investor who can handle uncertainty can usually boost the yield on a bond portfolio by investing a portion of it in securities that pose some default risk. Generally speaking, junk bonds--that is, below-investment-grade securities, often issued by heavily indebted corporations--and bonds issued by Third World countries pay between 3 and 10 percentage points more than debt issued by the Treasury. Interest rate risk crops up when inflation and interest rates are rising. A long-term bond bought when interest rates were higher yields much more than a bond bought today, and one bought in a time of lower interest rates now yields much less. Thus, the price on that higher-yielding bond will rise and the price on the lower-yielding bond will drop. How much it will drop depends on the bond's maturity--the amount of time the issuer has before it must pay the principal back--and the difference between going market interest rates and the return on the bond. According to an analysis by Oppenheimer Funds, a New York-based mutual fund company, the estimated value of a 2 1/2-year Treasury note will decrease by about 2% if interest rates rise 1 percentage point, but the value of a bond that matures in 20 years will decline by about 8%.

If you invest in bond mutual funds, which post their net asset values each day, you will see the effect of rising interest rates on your funds immediately. However, if you invest in individual bonds, you may not notice. That's simply because no one "marks their bonds to market"--that is, no one tells you the price you'd get if you were selling the bond today.

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But what types of bonds should you buy?

The answer depends on you. If you are in a high tax bracket, consider municipal bonds, because the interest is free from federal and state income taxes. To know whether municipals are a good deal for you, compare what the total return on a municipal would be to a return on a taxable bond. To do that, calculate the "taxable equivalent" yield. That allows you to make apples-to-apples comparisons between investment returns that won't be taxed and those that will. (See the work sheet on this page.)